Is Risk Modelling Dead? Maarten Gelderman Responses to the Crisis

Is risk modellingdead?

MaartenGelderman

Responses to thecrisis

Reform by nostalgia

Lessons for us

ModellingHow to evaluate modelshortcomings?

Why the crisis was not ablack swan

The Engle experiment

Wrap-up

Is risk modelling dead?or

How to kill a black swan

Maarten Gelderman

Head of Quantitative Risk ManagementDe Nederlandsche Bank

June 29, 2009


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

My key message

Our job is to kill the black swan.If this crisis is the death of risk

modelling, that’s our fault.


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Reform by nostalgia

I No large banksI No financial conglomeratesI Retreat to national boundariesI No proprietary tradingI No complex productsI No modelsI No performance-related payI A leverage ratio

Although not all outcomes of such an approach areundesirable, we risk ignoring the fact that the world haschanged and there effectively is no way back to the “goodold times”.


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Lessons for us

I Society wants more controlI We need to communicate betterI It doesn’t help to deny model failures (“25σ”)I Models are not reality


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

How to evaluate model shortcomings?

I Simplifications are only acceptable if they avoidworse simplifications,

I Simplifications are not acceptable if they give thewrong incentives

I Gaming (even within organisations)I Wrong decisionsI Herding behaviorI Giving a false sense of security

I Intentionally misleading models are not acceptableI Simplicifications are only acceptable if we

communicate about them openlyI A dillema: Is diversification beneficial for society?


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Is the crisis a unique event?

I Long-term perspectiveI Volatility and correlationI What is a realistic number of outliers (the Engle

experiment)


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Volatility of returns

08-0

2-19

9409

-05-

1994

05-0

8-19

9403

-11-

1994

01-0

2-19

9502

-05-

1995

31-0

7-19

9527

-10-

1995

25-0

1-19

9624

-04-

1996

23-0

7-19

9621

-10-

1996

17-0

1-19

9717

-04-

1997

16-0

7-19

9714

-10-

1997

12-0

1-19

9810

-04-

1998

09-0

7-19

9807

-10-

1998

05-0

1-19

9905

-04-

1999

02-0

7-19

9930

-09-

1999

29-1

2-19

9928

-03-

2000

26-0

6-20

0022

-09-

2000

21-1

2-20

0021

-03-

2001

19-0

6-20

0117

-09-

2001

14-1

2-20

0114

-03-

2002

12-0

6-20

0210

-09-

2002

09-1

2-20

0207

-03-

2003

05-0

6-20

0303

-09-

2003

02-1

2-20

0301

-03-

2004

28-0

5-20

0426

-08-

2004

24-1

1-20

0422

-02-

2005

23-0

5-20

0519

-08-

2005

17-1

1-20

0515

-02-

2006

16-0

5-20

0614

-08-

2006

10-1

1-20

0608

-02-

2007

09-0

5-20

0707

-08-

2007

05-1

1-20

0701

-02-

2008

01-0

5-20

0830

-07-

2008

28-1

0-20

0826

-01-

2009

24-0

4-20

09

0,000

0,005

0,010

0,015

0,020

0,025

0,030

0,035

0,040

sd MSCI sd UKP/USD sd EUR/USD


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Volatility and correlation of returns

08-0

2-19

9409

-05-

1994

05-0

8-19

9403

-11-

1994

01-0

2-19

9502

-05-

1995

31-0

7-19

9527

-10-

1995

25-0

1-19

9624

-04-

1996

23-0

7-19

9621

-10-

1996

17-0

1-19

9717

-04-

1997

16-0

7-19

9714

-10-

1997

12-0

1-19

9810

-04-

1998

09-0

7-19

9807

-10-

1998

05-0

1-19

9905

-04-

1999

02-0

7-19

9930

-09-

1999

29-1

2-19

9928

-03-

2000

26-0

6-20

0022

-09-

2000

21-1

2-20

0021

-03-

2001

19-0

6-20

0117

-09-

2001

14-1

2-20

0114

-03-

2002

12-0

6-20

0210

-09-

2002

09-1

2-20

0207

-03-

2003

05-0

6-20

0303

-09-

2003

02-1

2-20

0301

-03-

2004

28-0

5-20

0426

-08-

2004

24-1

1-20

0422

-02-

2005

23-0

5-20

0519

-08-

2005

17-1

1-20

0515

-02-

2006

16-0

5-20

0614

-08-

2006

10-1

1-20

0608

-02-

2007

09-0

5-20

0707

-08-

2007

05-1

1-20

0701

-02-

2008

01-0

5-20

0830

-07-

2008

28-1

0-20

0826

-01-

2009

24-0

4-20

09

0,000

0,005

0,010

0,015

0,020

0,025

0,030

0,035

0,040

-1

-0,8

-0,6

-0,4

-0,2

0

0,2

0,4

0,6

0,8

1

sd MSCI sd UKP/USD sd EUR/USD corr MSCI-USD/EUR corr UKP-USD/EUR


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Volatility and correlation of returns

30/0

4/09

14/1

0/08

02/0

4/08

17/0

9/07

05/0

3/07

16/0

8/06

01/0

2/06

19/0

7/05

03/0

1/05

21/0

6/04

03/1

2/03

21/0

5/03

04/1

1/02

23/0

4/02

05/1

0/01

19/0

3/01

31/0

8/00

17/0

2/00

05/0

8/99

21/0

1/99

08/0

7/98

19/1

2/97

09/0

6/97

21/1

1/96

10/0

5/96

26/1

0/95

13/0

4/95

29/0

9/94

16/0

3/94

01/0

9/93

18/0

2/93

05/0

8/92

22/0

1/92

10/0

7/91

24/1

2/90

12/0

6/90

27/1

1/89

15/0

5/89

28/1

0/88

18/0

4/88

02/1

0/87

20/0

3/87

05/0

9/86

21/0

2/86

07/0

8/85

23/0

1/85

11/0

7/84

27/1

2/83

14/0

6/83

30/1

1/82

18/0

5/82

02/1

1/81

21/0

4/81

03/1

0/80

21/0

3/80

07/0

9/79

23/0

2/79

10/0

8/78

26/0

1/78

13/0

7/77

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

0

0.01

0.01

0.02

0.02

0.03

0.03

0.04

0.04

0.05

0.05

S&P 500, 30YR T

Quick and Dirty

SD S&P 500 S&P-30YR


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Lessons

I Don’t ignore older dataI Model volatilityI Don’t look at average correlationI Less volatility is not always less risk!I Investigate correlation dependence on volatility


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up


I 2004 modelsI 2004 calibrationI ⇒Outliers within acceptable limits


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Using GARCH, DCC and extensionsS&P (Engle 2009)


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Using GARCH, DCC and extensionsHigh Low Book to Market (Engle 2009)


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Evalutation

I Models gave the wrong incentivesI Models gave a false sense of securityI Models were abusedI Better models were available


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

Wrap-up: how to kill a black swan?

I Be more humble and honestI Communicate betterI Leave more room for common senseI Improve modelling: kill simple volatility and simple

correlation (and possibly the normal distribution)


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

References I

Robert E. Engle.Anticipating correlations: a new paradigm for riskmanagement.The Econometric Institute Lectures. PrincetonUniversity Press, February 2009.

Robert C. Merton.On the science of finance in the practice of finance:Challenges and opportunities from the financialcrisis.Van Lanschot Lecture, Tilburg University, 2009.

Riccardo Rebonato.Theory and practice of model risk management.Unpublished Working Paper, Royal Bank of Scotlandand Financial Research Center Oxford University,2002.


MaartenGelderman


Reform by nostalgia

Lessons for us




Wrap-up

References II

Daniel K. Tarullo.Financial regulation in the wake of the crisis.Speech at the Peterson Institute for InternationalEconomics, June 2009.

Is Risk Modelling Dead? Maarten Gelderman Responses to the Crisis

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